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Lockheed Martin Corporation (LMT)

Founded in 1909, Lockheed Martin (LMT) is the world’s largest defense contractor and the biggest supplier of fighter aircraft. However, while the company is best known for its F-35 joint strike fighter, Lockheed Martin actually has four major divisions that combined to generate more than $50 billion in sales last year:

  • Aeronautics (39% of sales, 42% of operating profits): designs, manufactures, and maintains combat and air mobility aircraft, including fighter jets (F-22, F-35, and F-16), military transport planes, and unmanned air vehicles. The F-35 program is Lockheed Martin's largest program, generating 25% of its company-wide sales in 2017.

  • Missiles and Fire Control (14% of sales, 21% of operating profits): provides air and missile defense systems; tactical missiles and air-to-ground precision strike weapon systems; logistics; ground vehicles; and a variety of mission support services.

  • Rotary and Mission Systems (28% of sales, 18% of operating profits): builds and maintains military and commercial helicopters. Also designs ship and submarine mission and combat systems, including mission systems and sensors for rotary and fixed-wing aircraft, sea and land-based missile defense systems as well as radar systems, the Littoral combat ship, simulation and training services, and unmanned systems and technologies. This division also offers government cyber security services and specializes in military communication solutions.

  • Space Systems (19% of sales, 19% of operating profits): designs and builds satellites, strategic and defensive missile systems, and space transportation systems. This division is also where Lockheed designs its classified systems and services in support of national security.

Overall, Lockheed Martin generates 69% of its sales from the U.S. government, including 58% from the Department of Defense. Another 30% of Lockheed's sales are from international customers, including foreign military sales contracted through the U.S. government. 

Business Analysis

Many of the best dividend growth stocks generate growing and recurring sales, earnings, and cash flow, which are made possibly by durable competitive advantages that allow a company to protect its margins and returns on shareholder capital over time.

As an industrial company, and one that’s essentially 100% reliant on world governments for its business, Lockheed’s top line sales can be somewhat cyclical, especially as U.S. defense spending ebbs and flows. 

While the company operates in a highly capital intensive and sometimes unpredictable industry (thanks to budget deficit challenges), its military and government contracts also lock in relatively high profitability. As a result, Lockheed Martin has enjoyed fairly stable and generous profits over time. In fact, the company's operating margin has ranged between 9% and 13% each year over the past decade.

Stepping back, the nature of defense contractors can create substantial moats for some businesses. The highly complex and very expensive development costs of these weapons systems, as well as the Department of Defense’s (DOD) conservative approach to whom it works with (company trust, expertise, and reputation are everything in this business), mean that smaller, less well-capitalized rivals are essentially locked out of the market.

In fact, many of Lockheed’s DOD contracts are non-competitive, meaning the U.S. military's only option is to work with Lockheed because there are no other qualified bidders. In 2012, for example, Lockheed obtained $17.4 billion worth of non-compete contracts from the U.S. DOD, representing close to 40% of that year’s revenue, according to Morningstar.

And thanks to the company's $9 billion acquisition of Sikorsky Aircraft in 2015, Lockheed now has a massive business building and servicing its large fleet Black Hawk helicopters. Replacing, maintaining, and servicing this large sunk cost for the DOD means Lockheed enjoys a sticky business in military rotary aircraft as well.

The deal essentially added the world’s largest military helicopter maker by sales to Lockheed’s combat jet and missile-defense businesses. When combined with Lockheed’s divestiture of lower-margin government IT and services businesses, these moves further concentrated the company on military businesses with greater competitive advantages and improving growth prospects.

Overall, Lockheed Martin's trusted reputation for quality, longstanding customer relationships, and economies of scale have made it an ideal contractor for many of the U.S. government's aircraft and security needs. Working with a limited number of suppliers also helps the government achieve cost efficiency, further reducing the ability for new entrants to disrupt Lockheed Martin's business.  

Another benefit Lockheed has is that it sells internationally to allied militaries (30% of revenue), very few of which have the expertise or desire to take the time and money required to design their own homegrown weapons systems. 

In other words, relatively small nations find it much easier to outsource their defense needs from U.S. contractors. As a result, once a major weapons contract, such as the F-35 joint strike fighter, is obtained from the DOD, Lockheed essentially gains a near monopoly of fighter aircraft not just in the U.S., but also in the majority of the free world.

In fact, Lockheed is currently close to signing a deal with the DOD and 10 allied nations for delivery of 440 F-35s that would be worth $35 billion to $40 billion. Competition for international sales tends to be subject to U.S. government stipulations, such as export restrictions, which further tightens the grip Lockheed Martin has in many of these markets. 

However, it’s still important to note that the highly complex nature of these weapons systems is also a double-edged sword. That’s because it’s monstrously complex and expensive to build these jet fighters, including numerous subcontractors in a process that often takes decades of R&D and upgrades.

For example, the F-35 program, which Lockheed won the contract for in 2001, actually dates back to the late 1980’s. The $1.5 trillion program is designed to run through 2070, making it the most expensive military contract in history.

While this program certainly offers Lockheed immense long-term profit potential, it has also been plagued by various setbacks, including being more than a decade behind schedule and highly over budget, with cost overruns eating into Lockheed’s profits.

Fortunately, management is working with the DOD on its Blueprint for Affordability for Production (BFA) program, announced in 2014, to dramatically cut costs (by 35%) and maintenance expenses.

Lockheed also has a second cost saving program, the Sustainment Cost Reduction Initiative, in which it and its partners are investing $250 million in order to eventually cut annual expenses to build the F-35 by $200 million.

More importantly, Lockheed believes it can now profitably deliver F-35’s for just $75 million, which is $4 million lower than Boeing’s (BA) $79 million F/A 18 Super Hornet.

Still, the F-35’s cost per plane is 25% above what was originally planned for, which has caused numerous budgetary watchdog groups to lambast the program as the largest defense boondoggle in history.

In fact, a 2013 report from the RAND corporation concluded that it would have been much cheaper for the Air Force, Navy, and Marines to have designed their own custom planes, which would have also been far more capable than the F-35, which was burdened with the need to serve all branches simultaneously.

In other words, because the F-35 was designed to be a jack-of-all-trades, it has run into incredibly costly overruns and manufacturing delays.

That being said, Lockheed has spent the last few years ironing out the kinks in producing the jet, which accounted for 25% of company-wide sales in 2017, and expects ramped up and smoothed out production in the coming years to result in steady growth in its top and bottom lines (the F-35 program grew 18% in 2017).

That’s because the DOD plans to eventually purchase more than 2,400 of the jets. In fact, analysts expect Lockheed’s profits to grow by about 50% by 2020 due to the ramp up of F-35 production and delivery.

Since U.S. allies are similarly committed to the DOD’s “too big to fail” project, Lockheed’s strong backlog of orders (approximately $100 billion at the end of 2017) is likely to remain large and robust.

In fact, Lockheed’s backlog now represents about two years of total sales, meaning it has solid cash flow visibility so long as the company delivers on its projects on time and on budget.

In the meantime, the company is still generating strong returns on shareholder capital, as well as a solid free cash flow margin to support its steadily rising dividend.

Better yet, Lockheed’s management has proven to be one of the most shareholder-friendly teams in the industry, with the company returning approximately 80% of free cash flow (cash left over after running the business and investing in its growth) via buybacks and dividends in 2017.
Source: Lockheed Martin Earnings Presentation
As a result, Lockheed, while sure to face occasional challenges in the future (as will all U.S. defense contractors), is likely to continue to be a solid long-term dividend growth investment.

Key Risks

While Lockheed’s very long-term contract for the F-35 means that it has essentially guaranteed itself a lot of future growth, there are nonetheless numerous risk factors to keep in mind.

First, because of the company's large reliance on DOD contracts, Lockheed is very susceptible to any changes in military spending. As you can see below, the Department of Defense's base budget (dark blue lines) steadily declined starting in fiscal year 2012 as sequestration budget cuts set in. 

Fortunately for Lockheed, the Trump administration has made it a priority to invest more in America's military. DOD funding is projected to moderately grow each year going forward. The budget deal passed in February 2018 provides U.S. defense companies an extra $75 billion over the next two years, according to The Wall Street Journal.
Source: Vox.com, Defense Department
Besides funding risks posed by America's budget deficit, all defense contractors also face some other political risks, especially when defense platforms go wrong (as they usually do at some point).

For example, President Trump has publicly lambasted Lockheed for the cost overruns of the F-35, as well as the fact that the plane has badly failed to live up to expectations.

That’s because the plane was specifically designed to be stealthy, but that has come at the expense of reduced maneuverability and fighting ability.

In fact, in a 2015 mock battle with F-16’s (the plane the F-35 is meant to replace that was designed in the 1970’s), the F-35 proved to be less maneuverable and capable of dog fighting, even though it was unencumbered by external weapons mounts or fuel tanks.

The much older F-16s were still able to perform better than the state-of-the-art fighter, calling into question whether or not the next generation aircraft is a worthy replacement at all, or merely an overpriced (the U.S. military has invested more than $350 billion ) and overdesigned boondoggle that the DOD can’t undo.

Since almost all DOD contracts are now fixed cost, any cost overruns are mainly paid for by Lockheed, meaning that if it runs into unexpected problems delivering on weapons systems, its earnings can be badly affected. In fact, back in the 1970’s and 1980’s, several defense contractors nearly went bankrupt due to such issues.

The F-35 is hardly the only issue for Lockheed. For example, its Sikorsky acquisition has not gone as smoothly as expected, with cost synergies coming along slower than anticipated. In addition, Sikorsky sales are expected to be remain sluggish as it faces increasing competition from Airbus Helicopters and Bell in the commercial helicopter space.

Meanwhile, missile systems are only expected to generate small growth, more than offset by the lagging space systems division (which is projecting double-digit declines).

Lockheed has enjoyed a duopoly position in missiles (with Raytheon) and space (United Launch Alliance joint venture with Boeing) for a long time; however, increased competition from Elon Musk’s SpaceX and Jeff Bezos’s Blue Origin could threaten to undermine lucrative satellite delivery contracts with the DOD, which represent approximately 15% of this division’s sales.

Lockheed has responded with a plan to cut the price of launching government satellites, but SpaceX is now successfully using self-landing, reusable rockets that Lockheed might find difficult to match unless it can design its own reusable models. That’s a highly complex and expensive endeavor, and one that Lockheed has no guarantees of success in since its competitive advantages appear to be much shallower in this industry.

The bottom line is that Lockheed appears to have a near global monopoly on fighter aircraft and enduring advantages in its military helicopter, military satellite, and nuclear missile businesses. This will likely ensure the company achieves modest growth in the coming years and decades, especially as F-35 deliveries continue ramping up.

However, the company's other divisions are struggling and seem to possess less significant competitive advantages. This could drag somewhat on long-term sales growth, which is why investors may not be able to rely on the company being able to grow its dividend at the impressive double-digit pace enjoyed over the past 30 years.

Closing Thoughts on Lockheed Martin

As the largest defense contractor in the world, Lockheed Martin enjoys substantial competitive advantages in numerous highly-specialized industries.

Combined with a large order backlog, which is likely to only grow over time as defense spending continues increasing the next few years, the company appears to offer dividend growth investors a highly secure and steadily-rising income stream.

Lockheed can be an attractive choice for a diversified dividend growth portfolio, but it's important for investors to buy the company at a reasonable valuation, especially given the recent high level of enthusiasm over America's rising defense budget.

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